Classification of Rental Income as Business Income

According to case law, income is generally classified as business income when it results from substantial, ongoing, cyclical, and systematic activity, and its generation requires personal effort. When the rental is classified as business rental, the tax rate will be the marginal tax rate only, and it is not possible to ### There are auxiliary tests to determine whether the income is fruit (ordinary) income or capital income.

If most of the tests indicate fruit income, the rental will be classified as business rental:

• Nature of the Asset Test: Retail has a more commercial nature than real estate.
• Scope of the Transaction Test: The larger the scope of the transaction, the more likely the income will be recognized as business income.
• Frequency Test: Higher frequency will lean towards fruit income. For example, in the case of apartments with partners where there is a higher turnover of tenants, etc.
• Involvement and Activity Test: The more involvement and activity, the more likely it will be fruit income.
• Expertise Test: Expertise and knowledge will lean towards fruit income.
• Financing Test: Usually, long-term external financing leads to the definition of a capital transaction compared to short-term independent financing.
• Holding Period Test: A short holding period indicates business activity.
• Improvement Test: The more improvement or attempts at improvement, the more it is a characteristic of business and entrepreneurship.
• Circumstances Test: The most comprehensive and important test! Ultimately, the court weighs all the indications and decides whether, in light of all the factual indications, it is reasonable to determine that it is a recurring and ongoing business activity or passive activity.

Our office has extensive experience with cases where the tax authority disputed the attribution of income and determined it was business income. In many cases, it is advisable to obtain an opinion on this matter in advance to reduce criminal and civil exposure to claims by the Tax Authority.

Cases Leshem and Biran; the Tax Authority’s Position – Indication of the Number of Assets

In the Leshem case, the classification of rental income received by two brothers from renting over twenty properties they owned, most of which were residential apartments, was discussed. In the Biran case, the classification of rental income received by a lawyer engaged in real estate from renting more than twenty residential apartments was discussed. The main question in these rulings was whether it was business income or passive rental income. In such cases, one could choose the 10% tax path or the partial exemption. The court ruled that the rental income received by the taxpayers should be considered business income subject to tax under Section 2(1) of the Ordinance and not passive income. Consequently, the provisions of Section 122 of the Ordinance do not apply to the rental income they earned.

The renewal in these rulings is the greater emphasis on the scope of the assets over other auxiliary tests. This effectively determines that renting out more than 5-10 apartments constitutes an indication of business income and shifts the burden of proof to anyone claiming otherwise.

Additional Considerations According to These Rulings:

• A broad scope of rental income will lean towards classifying the income as business income.
• -When the landlord’s rental income is higher than their other income, the management mechanism of the rental activity, such as marketing and collection, will lean towards classifying it as business income.
• The shorter the rental period, the more it will lean towards classifying the income as business income.
• The tests should be considered cumulatively, with greater weight given to the asset quantity test.